A Project Has The Following Cash Flows Profitability Index Investment Evaluation Criteria

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Investment Evaluation Criteria

Investment appraisal involves three steps:

• Cash flow forecasting

• Estimation of required rate of return (capital ratio)

• Use of decision rules for decision rules to make choices

Investment decision rules

Investment decision rules may be referred to as capital budgeting techniques or investment criteria. Appropriate valuation techniques should be used to measure the financial value of an investment project. The essential property of sound technology is to increase shareholder wealth. The following other characteristics should also be possessed as per proper investment evaluation criteria:

• All cash flows should be considered to determine the true profitability of the project at that time.

• An objective and unambiguous way of distinguishing good projects from bad projects should be provided.

• It should help ranking the projects according to their actual profitability.

• Recognize the fact that large cash flows are preferable to small ones and early cash flows are preferable to later amounts.

• It should help in selecting the project that maximizes shareholder wealth from among mutually exclusive projects.

• It should be a criterion that applies to any conceivable investment project independently of others.

These terms will be explained as we discuss the specifics of various investment criteria in the following posts.

Investment Evaluation Criteria

Many investment appraisal criteria or capital budgeting techniques are in use in practice. They can be grouped into the following two categories:

1. Criteria for discounted cash flows

• Net present value

• Internal rate of return

• Profitability Index (PI)

2. No relaxation of cash flow criteria

• Payback period

• Accounting rate of return

• Discounted payback period

Discounted payback is a variation of the payback method. It includes the discount method, but it is not a true measure of investment profitability. We will show in our next post that the net present value criterion is the most valid technique for evaluating an investment project. This is consistent with the objective of maximizing shareholder wealth.

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